By Saqib Iqbal Ahmed, Carolina Mandl and Laura Matthews

NEW YORK (Reuters) -Investors are expecting Republican gains in U.S. midterm elections, a result that will likely scale back Democratic spending and regulation but set up a bruising fight over raising the U.S. debt ceiling next year.

Republicans are favored to win control of the House of Representatives and possibly the Senate, polls and betting markets show, though there are still hours left to vote in many districts. With Democratic President Joe Biden in the White House, that result would lead to a split government, an outcome that has been accompanied by positive long-term stock market performance in the past.

While macroeconomic concerns and Federal Reserve monetary policy have been the market’s key movers this year, Capitol Hill politics could exert its own influence on asset prices.

A Republican win would cut down on fiscal spending that could exacerbate already-high inflation and lead the Fed to raise interest rates even higher than expected, analysts at Morgan Stanley wrote earlier this week, potentially buoying the stock market’s most recent rebound while supporting Treasury prices and helping curb the burgeoning dollar.

“I think the markets are rallying at the prospect of gridlock,” said Jack Ablin, chief investment officer at Cresset Capital in Chicago. “Fiscal spending has created a challenge for central banks worldwide. The prospect of no legislation is a bullish inflation signal.”

Historically, stocks have tended to do better under a split government when a Democrat is in the White House, with investors attributing some of that performance to political gridlock that prevents either side from making major policy changes.

Average annual S&P 500 returns have been 14% in a split Congress and 13% in a Republican-held Congress under a Democratic president, according to data since 1932 analyzed by RBC Capital Markets. That compares with 10% when Democrats controlled the presidency and Congress.

“If we get a split Congress, we might have to adjust our portfolios to be less defensive than we are today,” said Brooks Ritchey, Co-CIO at K2 Advisors.

The S&P 500, which finished up 0.6% on Tuesday, has risen about 5% over the last month. The index is down about 20% for the year.

Over the longer term, however, a split government could lead to heightened tensions over raising the federal debt ceiling in 2023, setting up the kind of protracted battle that led Standard & Poor’s to downgrade the U.S. credit rating for the first time in 2011, sending financial markets reeling.

“If the Republicans really gain some power here, in the House and Senate, they can make (raising the federal debt ceiling) a really difficult process,” said Tim Ghriskey, senior portfolio strategist Ingalls & Snyder in New York.

With U.S. equity options market positioned for relative calm, a surprisingly strong showing by the Democrats could throw the markets for a loop.

Options positioning on Monday implied a decline of 1.5% in the S&P 500 on the day after the vote should Democrats pull off a stronger-than-expected showing, according to Tom Borgen-Davis, head of equity research at options market making firm Optiver.

PERFECT TRACK RECORD

Many strategists are also quick to cite the stock market’s perfect post-midterms track record: The S&P 500 has posted a gain in each 12-month period after the midterm vote for 19 straight occasions since World War Two, according to Deutsche Bank.

Still, some investors cautioned against expecting a repeat this time around, when there is little clarity on how quickly the Fed will be able to tame inflation or end its market-bruising monetary tightening.

One important potential catalyst comes Thursday in the form of the U.S. consumer price report, a data point that has spurred sharp market moves throughout 2022.

“Next year’s earnings estimates are still too high, Fed policy is still tight and tightening, inflation is still too high,” said James Athey, investment director at Abrdn. “This is all bad news for equities.”

(Reporting by Saqib Iqbal Ahmed, Carolina Mandl and Laura Matthews; Editing by Ira Iosebashvili and Jonathan Oatis)